The Pros and Cons of the Three Basic Inventory Techniques

Inventory is one of the basics of accounting, but it can make or break a business. I have worked at a Retail Store for a couple of years now and have seen firsthand the importance of keeping inventory not only up to date, but correct as well. If the computer says you have one item on-hand, but in reality you have none, the store will lose money for that item in sales. Also, they will be counting that item in their inventory when they actually do not have it in their store. Inventory also applies to items used to make merchandise. For instance, a screw or piece of wood used to make a desk. Inventory is the physical assets that a company has, that can be sold or used to manufacture products for sale. A company’s inventory changes quickly and because of this companies need a method to keep track of the entire inventory that they own when they are working on their accounting records. There are three methods which are used: FIFO, LIFO, and Weighted Average. Each concept is basic in idea, but very different from the others. Also, each one has their own advantages and disadvantages, which can have a completely different impact on the inventory cost and cash flow statements.

The first technique is FIFO, which stands for first-in, first-out. It is used generally when selling a lot of the same item or perishable goods. FIFO is mostly used when the economy is stable, but high inflation can create “inventory profits” which will make the value of the company’s inventory look better. Small companies are usually the ones that take advantage of this because it increases their value for mergers and loans, as well as, increasing their stock value. The main disadvantage of FIFO is that companies will have to pay more taxes due to reporting higher profits on their statements. A lot of companies would rather take the minimal profits to avoid paying out taxes to the government in the end.

LIFO is pretty much the complete opposite of FIFO. It stands for last-in, first-out. Using this method companies will sell the last items purchased in their inventory, which leaves the oldest inventory left over. In FIFO companies are reporting a false profit which will lead to higher taxes. When using LIFO companies are reporting lower profits. This means lower taxes for companies. That is why LIFO is the preferred inventory accounting method by companies. Now I will show you the disadvantages of LIFO. What happens to that older inventory? Most companies never use it and lose money because of it. They can liquidate the merchandise, but then they have to report a higher profit and pay out taxes. Companies would rather have the merchandise sit in the warehouse where it goes to waste. Another disadvantage is that if they do sell the merchandise that has been sitting in the warehouse they will get less in return for it because of rising costs.

The last technique that companies use is Weighted Average. When using this method companies would take the average cost for all units. To further explain, let’s say you had 300 chairs. The cost for the 200 when you acquired them was $20 apiece and 100 of them for $10 apiece. The two costs are different so you would need to find the average to place on the financial sheet. To do this you would do [($20*200)+($10*100)]/300. So, you would list the chair cost at $16.67. Although this process is somewhat easy to calculate, it can still lead to its fair share of mistakes. Also, the average cost may not reflect inflation well. If we use our example again the costs are relatively close. But, if the cost of the chairs suddenly skyrocketed to $50 it is going to throw off the average considerably.

As you can see all of these methods have their advantages and disadvantages which can sway a company’s decision on which to use. They are very important to understand even if you have no desire to understand how a business works because they all affect the merchandise that we see in stores. For example, every time you buy food from a supermarket, that store is probably using the first-in, first-out method to make sure that the food is safe for you to eat. What if that company put that food item out after it was sitting in the stockroom for months? You could get sick and sue the company for selling you food that was out of date. So, keeping track of inventory is a really important task.

Article courtesy of articlesbase.com. You can find the article at: http://www.articlesbase.com/business-articles/the-pros-and-cons-of-the-three-basic-inventory-techniques-3243055.html.